Merrill Lynch's Small Cap Strategist: Rally Could Fizzle

Steven DeSanctis, in a note Monday, said the surge in the Russell 2000 of more than 30 percent since March 8 is very similar to the 30 percent November to January rally.

He says the rally could end sooner rather than later, and he expects a choppy performance and wide trading range for small caps in 2009.

But he does not expect the March lows to be broken.

Small caps can lead the broader market out of a bear market, but this does not appear to currently be the case. DeSanctis points out that volatility is still up on a year-over-year basis, and in 20 percent of the trading days this year, the Russell has seen 5 percent intraday swings between high and low.

Another factor is earnings, which are expected to fall more than 40 percent in the first quarter for his universe of small caps. He said they will have worse earnings than large caps for the first time in six quarters.

Credit and capital availability are also key indicators, and DeSanctis said there has not been much improvement. The high-yield spreads narrowed marginally in the past month but still are at very high levels, and high yield financing actually slowed, he says in the note.

The spring rally has been led by the smaller small caps, which rose 22 percent for the month, along with stocks under $5, which are up 13 percent. "The smaller small caps tend to bounce the highest and that is what we saw last month. Since 1926, one year after a bear market ends, the micro caps have posted a median gain of 43.4 percent versus a rise of 41.4 percent for the small caps, and this easily tops the large caps at 32.4 percent and the mid caps at 37.3 percent," he said in the note.

"...these are classic moves when the market starts to show signs of improvement, but the longer lasting moves tend to be driven by improvements in credit, the economy, earnings etc."

DeSanctis says earnings expectations need to fall further to match the more typical decline of 20 percent during a recession. The 2009 forecast is for a drop of about 13.1 percent, and if homebuilders are left out, the decline would be 18.4 percent.

Check Out The Russell 2000

He does say one trend should continue and that is the outperformance of growth stocks. The difference between the Russell 2000 growth and Russell 2000 value is about 1000 basis points. He said valuations for growth are still compelling, compared to value, and earnings have held up much better. He said when bear markets and recessions end, growth bounces higher and he continues to overweight it.

He says stick with quality and be "growthier" than the index. He continues to overweight health care and tech.